May 6, 2014 6:20 pm

Italy’s borrowing costs fall as investors bet on ECB buying debt

Italy’s benchmark government borrowing costs fell to a record low on Tuesday as investors betting on bond-buying by the European Central Bank snapped up eurozone debt.

For the first time since the euro was introduced, the yield on Italy’s 10-year bonds dropped below 3 per cent, in line with the wider rally in debt issued by Europe’s “periphery” countries.

“This is the story of the year,” said Philip Brown, head of sovereign debt markets at Citi.

Better-than-expected business growth in the eurozone in recent months has supported investor belief that Europe is recovering from its debt crisis, but bankers say the real source of appetite is a hunger for yield and speculation about possible action by the European Central Bank.

“The market has not been trading on fundamentals but on the expectation that Europe will do whatever it takes to remain intact,” said Mr Brown.

In the face of possible eurozone deflation, investors are wondering whether the European Central Bank might also engage in some form of quantitative easing, buying bonds to push down yields and raise asset prices.

Confidence in peripheral Europe has been healthy since the ECB president Mario Draghi’s 2012 promise to save the euro, particularly among investors who want a higher yield than the sub-1.5 per cent offered by German government debt. Their demand has pushed up prices, which in turn has pushed down yields.

The yield on Italy’s benchmark government debt dropped beneath 2.99 per cent on Tuesday before closing slightly higher. It follows a similar movement in yields on equivalent Spanish bonds, which fell below 3 per cent last week for the first time on record.

Three years ago Portugal was bailed out by international lenders, now the yield on its 10-year bonds is at 3.57 per cent, the lowest rate since the financial crisis began, after the country announced that it would leave the bailout programme without a back-up loan - seen by investors as a sign of confidence.

Falling yields mean that the premium investors receive for buying Spanish, Portuguese and Italian debt instead of safer German bonds has been sharply reduced. Traders said that the milestones reached in recent weeks have been symbolic of Europe’s recovery.

Darren Ruane, head of fixed income at Investec Wealth & Investment, said that bond investors such as pension funds and insurers were being forced to take on more risk than they wanted as they hunted for yield.

“Economic forecasts have improved in Europe but you could argue that not all of the risk is being priced into bonds. There’s little to stop the trend from carrying on for the next six months but the interesting question is at what point will investors stop wanting to buy peripheral European bonds because there is too much risk for the reward.”

As the eurozone crisis recedes, Ireland, Spain and Portugal are now well placed to earn a credit rating upgrade, according to one of the world’s largest credit rating agencies.

Fitch Ratings has already cut the risk rating for sovereign debt in Greece and Spain and announced an improvement in its outlook for Ireland, Cyprus, Italy and Portugal.

The agency said that structural reforms and the reduced tail risk of eurozone exits put the countries in the best position for upgrades as their ratings fell further in the crisis than other countries, such as Italy. However, it stopped short of predicting that any country in the periphery of the eurozone would return to pre-crisis rating in the foreseeable future.

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